The accounting profession has been increasingly
subject to damages for professional negligence. The chairman
of the US firm Coopers and Lybrand, estimates that the profession
as a whole faces an estimated US$30 billion in damage claims.
That estimate may prove on the low side after the raft of unauthorised
derivative trading cases such as Barings and Sumitomo Bank reach
the courts. Recent decisions in Hong Kong, Australia and the
United Kingdom expand the circumstances in which an auditor may
be held liable for negligence while opening the door to several
novel defenses.
This article will briefly present an overview of the legal basis for a claim for damages for negligence against an auditor, the current state of the law in Hong Kong and suggest some measures which auditors may adopt to improve their positions.
By his contract with his client, an auditor
owes a duty to perform the audit, report or investigation for
which he was engaged exercising reasonable care. He may have
a duty towards others who are in sufficient proximity to
exercise care as well.
The duty of care has been defined as doing the things that a prudent
man would do in the circumstances and refraining from those things
he would not do. In the case of an auditor engaged to audit a
company's accounts, this presumably means that the audit will
be conducted in accordance with accepted accounting standards
and standards of audit practice.
The duty of care would require that the audit be properly pre-planned
given the inherent risks of the client company, be carried out
by qualified personnel who in turn are supervised by experienced
audit leaders, be reviewed by an audit partner and that any anomalous
situations be the subject of further investigation to eliminate
the possibility of mistake or fraud. It is now well established
that the audit team may not blindly rely on statements made by
management since the majority of irregularities found on audit
are perpetrated by management and 80% are material.
Certainly it is crucial for the auditor to set out clearly, both in the letter of engagement and in the resulting report, the scope of the assignment and any exclusions from the engagement. For example, in an audit of a Hong Kong company with a branch in Singapore in which Singapore auditors will be relied upon for the branch audit, these conditions should be stated. Where valuations are material to the report, the auditor must not only exercise care in choosing the appraisers but also subject the valuation to a reasonableness check and investigate further if it fails.
The auditors owe their primary duty to the
client company and the relationship has traditionally been viewed
as confidential. The company is represented by management, the
directors and ultimately the shareholders. If fraud is suspected
or even an absence of controls found, the auditors have a duty
to:
"…report the acknowledged absence of proper controls
and the weaknesses in internal controls to management and then,
in the absence of appropriate and timely action, to the board."
The auditors may have other statutory duties to report fraud such as obligations under the Companies Ordinance, the Banking Ordinance and the Stock Exchange as well as the general duty of every citizen to report a crime. A violation of these duties will most certainly give rise to a civil claim and can in some circumstances give rise to criminal liability. While Hong Kong has not yet gone as far a the UK in this area, nevertheless, the least an auditor should do if frustrated in following up on questionable transactions is to resign and file a statement expressing its concerns under sec. 140A of the Companies Ordinance.
There is no question but that the duty of
care is owed to the client company by the contract itself. It
is well established that the shareholders of the client are indistinguishable
from the client for these purposes and they can recover losses
only through the company. This would then seem to exclude an
action by a shareholder for the loss of the market value of shares.
However, a recent Australian decision, Daniels & Ors
t/a Deloitte Haskins & Sells v AWA has held directors
and auditors liable to purely economic losses relying on US, Canadian
and UK precedents. This reasoning could lead to direct suits by
shareholders or lenders for losses distinct from the losses of
the company.
Where the client is a subsidiary in a group the contract may well be with the holding company, that is the shareholder as well as the client. This could be significant where negligence results in loss to the shareholder but not to the company audited as, for example in a failed sale of the subsidiary.
The right of a person other than the company
contracting the audit to claim for negligence arises out of the
law of torts. The leading case in this area is a 1990 House of
Lords decision, Caparo Industries PLC v. Dickman & Ors.
This decision was recently quoted in a Hong Kong Court of Appeals
case, Xui Siu Finance Company Limited v. Agnew & Ors t/a
Deloitte Haskins & Sells, by Litton V-P as follows:
" The salient feature in all these cases is that the defendant
giving advice or information was fully aware of the nature of
the transaction which the plaintiff had in contemplation, knew
that the advice would be communicated to him directly or indirectly
and knew that it was likely that the plaintiff would rely on the
advice in deciding whether or not to engage in the transaction
in contemplation. In these circumstances the defendant could
clearly be expected, subject always to the effect of any disclaimer
of responsibility, specifically to anticipate that the plaintiff
would rely on the advice or information given by the defendant
for the very purpose in which he did in the event rely on it.
So the plaintiff, subject again to the effect of any disclaimer,
would in that situation reasonably suppose that he was entitled
to rely on the advice or information communicated to him for the
very purpose for which he required it."
In this case, Simister, an investor, entered an agreement to purchase
a substantial shareholding of two subject companies, Texxon
Industries and Chino Industries from John Koon pursuant to a contract
which provided an adjustment to the purchase price and a 30 day
put option to the buyer if the aggregate combined profits of the
companies was outside a certain range. Deloitte Haskins &
Sells and Ho & Ho were engaged as joint auditors to perform
a special audit for the eight month period ending on the date
of the sale. Any payment of the adjustment or exercise of the
put option required a certificate by the joint auditors. The
auditors signed the audit which showed combined profits within
the range so that no adjustment was called for and the put option
could not be exercised. No certificate was asked nor furnished.
The plaintiffs later claimed that the profits shown were illusory due to bad debts and other problems and brought the action against the auditors for negligence. The defendants sought that the claim be struck out before trial on the basis that the plaintiffs had no contract with the defendants and the defendants assumed no responsibility towards the plaintiffs. The court below held for the defendants and the Court of Appeals reversed holding that it was not necessary for the plaintiff to show that the defendants intended for the plaintiff to rely on the report but merely that the defendants knew or should have known that the plaintiffs would rely on the report.
Previous cases have often held auditors liable,
jointly and severally, for the damage to the plaintiff.
Where the auditor has 'deep pockets' this may result in them
becoming responsible for the entire amount of the damage award
and then seeking to obtain contributions from director co-defendants
who may be judgment proof.
Generally concurrent wrong doers causing the same damage
will be held to joint liability whereas concurrent wrong doers
causing separate damage will be held only severally.
Where the directors facilitate fraud over time and the auditors
later fail to uncover it, it can be argued that the damages are
separate and the liability should be several but not joint. The
difference is that the auditors who may be 20% responsible for
the total damages are not responsible for the balance. This
was the result in a recent decision of the New South Wales Full
Court, Daniels & Ors v. AWA Ltd.
Sec. 165 of the Companies Ordinance provides
that any provision exempting or indemnifying an auditor for :-
"any liability which by virtue of any rule of law would otherwise
attach to him in respect of any negligence, default, breach of
duty or breach of trust of which he may be guilty in relation
to the company shall be void:" [emphasis added]
Sec 165( c) provides that a company may indemnify an auditor against
the liability incurred in defending such a claim "if judgment
is in his favour or in which he is acquitted or in connexion with
any application under section 358 in which relief is granted by
the court." Section 358 permits a court to relieve an auditor
in whole or in part from liability for negligence if he has acted
'honestly and reasonably having regard to all the circumstances
of the case'.
An auditor may therefore request an agreement from the company
which provides for indemnification of costs and damages in the
following circumstances:-
It is generally believed that an auditor may require that the directors of the company purchase for the auditor professional liability insurance covering the auditors engagement. This approach has not been tested in court. It would appear that the policy should be assigned absolutely to the auditor prior to the audit.
The House of Lords in Caparo Industries
v. Dickman specifically admitted the possibility of a disclaimer
in the audit report itself. Thus something along the lines of
" This report is submitted for the guidance of the directors
of X company only and may not be disclosed to any third party
without the prior written authorisation of Y auditors except as
provided by law. No third party is entitled to rely on this report
for any purpose whatsoever. Y auditors specifically declines
responsibility for the use of this report by any person other
than the directors or for any purpose other the purpose for which
it was submitted".
There can be no assurance that such a clause would serve its purpose but "it cannot hurt ©"
The accounting profession faces danger from
claims of professional negligence as both case law and statutes
hold auditors to stricter standards toward a wider class of persons
who may access its work product. Auditors should take a close
look at their procedures and adopt sensible precautions for the
future.
John Beukema, Solicitor
Littlewoods, Solicitors
15th Floor HongkongBank Building
673 Nathan Road
Kowloon
Hong Kong